Fall 2003 Workshops

Law and Economic Studies

September 8, 2003

Oren Bar-Gill, The Society of Fellows, Harvard University Law School, The Olin Center for Law, Economics and Business

Seduction by Plastic

Abstract - In consumer contracts highly sophisticated corporations will often exploit consumers' behavioral biases. Competition cannot cure such exploitation. On the contrary, competitive forces compel sellers to take advantage of consumers' weaknesses. This general theme is demonstrated through a detailed case stud7y of te credit card market. In designing the credit card contract, issuers deviate from efficient marginal cost pricing in order to take advantage of consumers' underestimation of their future borrowing. This prevalent bias explains several puzzling features of the credit card contract, including high interest rates, zero annual and per transaction fees, teaser rates, high late and over-limit fees, benefits programs and low (and even negative) amortization rates. The identified market failure suggests that legal intervention may well be required to protect consumers and to increase social welfare. Such intervention is immune against the freedom of contract critique. When one party enters a contract blinded by a behavioral bias, the other party cannot rely on freedom of contract as a shield against legal scrutiny. The law may intervene through ex ante regulation, specifically through the imposition of usury ceilings, or through ex post review, by broadening the reach of contract law (e.g. the penalty doctrine and the doctrine of unconscionability) and bankruptcy law. Revising TILA to achieve effective disclosure that might be able to overcome the underestimation bias is also considered. More broadly, the credit card case study demonstrates that pricing anomalies should be used as indicators f market failure, signaling the need for legal intervention.Bar-Gill - 03.pdf

September 22, 2003

Stephen Choi, University of California at Berkeley, Law School

Behavioral Economics and the SECAuthored with Adam Pritchard

Abstract - Investors face myriad investment alternatives and seemingly limitless information concerning those alternatives. Not surprisingly, many commentators contend that investors frequently fall short of the ideal investor posited by the rational actor model. Investors are plagued with a variety of behavioral biases (such as, among others, the hindsight bias, the availability bias, loss aversion, and overconfidence). Even securities market institutions and intermediaries may suffer from biases, led astray by group think and overconfidence. The question remains whether regulators should focus on such biases in formulating policy. An omnipotent regulatory decision maker would certainly improve on flawed investor decision making. The alternative we face, however, is a behaviorally-flawed regulator, the Securities and Exchange Commission (SEC). Several behavioral biases may plague SEC regulators including overconfidence, the confirmation bias, framing effects, and group think. While structural solutions are possible to reduce biases within the agency, we argue that such solutions are only partially effective in correcting these biases. Instead of attempting to determine when the behavioral biases of regulators outweigh those within the market, we take a different tactic. Because behaviorally flawed (and possibly self-interested) regulators themselves will decide whether market-based biases outweigh regulatory biases, we propose a framework for assessing such regulatory intervention. Our framework varies along two dimensions. The more monopolistic the regulator (such as the SEC), the greater is the presumption against intervention to correct for biases in the market. Monopolistic regulatory agencies provide a fertile environment for behavioral biases to flourish. Second, the more regulations supplant market decision making, the greater is the presumption against such regulations. Market supplanting regulations are particularly prone to entrenchment, making reversal difficult once such regulations have become part of the status quo.Choi - Fall 03.pdf

October 13, 2003

Abstract - We present a multiperiod agency model of stock based executive compensation in a speculative stock market, where investors are overconfident and stock prices may deviate from underlying fundamentals and include a speculative option component. This component arises from the option to sell the stock in the future to potentially over optimistic investors. We show that optimal compensation contracts may emphasize short-term stock performance, at the expense of long run fundamental value, as an incentive to induce managers to pursue actions which increase the speculative component in the stock price. Our model provides a different perspective for the recent corporate crisis than the increasingly popular `rent extraction view' of executive compensation.Bolton - Fall 03.pdf

October 27, 2003

Albert H. Yoon, Northwestern University School of Law, Visiting Princeton

The End of the Rainbow:Understanding Turnover Among Federal Judges

Abstract - When Article III judges conclude their tenure of active service, they effectively abdicate their seat and enable the President and Senate to select a successor. Judicial scholars have concluded that political factors both within and across institutions largely influence this decision. In this Article, I construct a dataset that allows me to analyze, year by year, judicial turnover. Since the creation of a judicial pension in 1869, eligibility for which is determined by chronological age and years of active service, judges have increasingly synchronized their departure from active service with their qualification of the pension. By comparison, political and institutional factors, as well as other individual judge characteristics, appear to have little influence on turnover rates. These findings contradict much of the existing scholarship on judicial turnover and also offer more viable alternatives to existing calls for judicial reform.Yoon, Albert H. - Fall 03.pdf

November 10, 2003

Iris Bohnet, Harvard University, Kennedy School of Government

Is Trust a Bad Investment?Authored with nava Ashraf and Nikita Piankov

Abstract - This paper examines whether trust is an investment decision under uncertainty, based on the expectation of trustworthiness, and whether trustworthiness is reciprocity, conditional on one's counterpart's behavior. We focus on one-shot interactions between strangers and run investment games, dictator games and risky choice tasks in Russia, South Africa and the United States, using a within-subject design. We find that only about one third of the subjects who trust expect to make money. Women's trust is almost completely accounted for by their expectations of return while men's trust is also motivated by unconditional kindness. Reciprocity drives Americans' trustworthiness. Russians and South Africans' trustworthiness is related to kindness.

Abstract - Using experiments, we examine whether the decision to trust a stranger in a one-shot interaction is equivalent to taking a risky bet, or if a trust decision entails an additional risk premium to balance the costs of trust betrayal. We compare a binary-choice Trust game with a structurally identical, binary-choice Risky Dictator game with good or bad outcomes. We elicit individuals' minimum acceptable probabilities (MAPs) of getting the good outcome such that they would prefer the gamble to the sure payoff. First movers state higher MAPs in the Trust game than in situations where nature determines the outcome.Bohnet, Iris - Fall 03 - primary paper.pdfBohnet, Iris - Fall 03 - secondary paper.pdf

November 24, 2003

Abstract - Records of 793,794 employees eligible to participate in 647 defined contribution pension plans are studied. About 71% of them choose to participate in the plans, and of the participants, 12% choose to contribute the maximum allowed, $10,500. The main findings are (other things equal) (i) participation rates, contributions and (most remarkably) savings rates increase with compensation; on average, a $10,000 increase in compensation is associated with a 3.7% higher participation probability and $900 higher contribution; (ii) women's participation probability is 6.5% higher than men's and they contribute almost $500 more than men; (iii) participation probabilities are similar for employees covered and not covered by DB plans, but those covered by DB plans contribute more to the DC plans; (iv) the availability of a match by the employer increases employees' participation and contributions; the effect is strongest for low-income employees; (v) participation rates, especially among low-income employees, are higher when company stock is an investable fund.http://www.columbia.edu/~wj2006/Vanguard_PartContr.pdf

December 8, 2003

Fred C. Dunbar - National Economic Research Associates, Inc.

Fraud on the Market Meets Behavioral Finance

Abstract - The efficient market hypothesis, in its current form, dates academically from 1970 and was first accepted by a Federal Court in a shareholder class action in 1975 providing plaintiffs with a rebuttable presumption of reliance based on the fraud on the market theory. By 1989, the fraud on the market theory was the law in most Circuits and was affirmed by the Supreme Court in Basic v. Levinson. Since then, the efficient market hypothesis has not been rebutted in any case involving actively traded securities and its impact on securities litigation and regulation extends well beyond class certification to materiality, causation and damages. Somewhat ironically, over the same time period, financial economics was, first, finding anomalies in securities markets that were not consistent with the Supreme Court's version of the efficient market hypothesis and, second, using concepts borrowed from behavioral economics to develop theories of securities price formation to explain, among other things, the stock price bubble of the late 90s. In fact, even proponents of the efficient market hypothesis have claimed that securities were mispriced during this episode. If courts were to adopt behavioral finance explanations of securities market behavior then prior precedent would not be appropriate in a number of areas of securities fraud including reliance, materiality, causation and damages. We explore the implications of how analysis of these issues would be changed by application of behavioral finance.Dunbar, Fred C. - Fall 03.pdf